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Wednesday, October 6, 2010

Section 2511(c) and the Uncertain State of the Estate Tax


It’s been almost nine years since the Economic Growth and Tax Relief Reconciliation Act of 2001 called for the federal estate tax to be repealed in 2010 — and reinstated in 2011. The one-year repeal was a political compromise required to get the bill passed, so most observers assumed that Congress would intervene either to extend the tax or to make the repeal permanent. But 2009 came and went with no new estate tax legislation.

The temporary nature of the repeal, together with uncertainty over what Congress will do next, has created an estate planning quagmire. In addition to the repeal itself, EGTRRA made several other significant changes — for 2010 only — that make long-term planning a challenge. These include a new tax code provision, Section 2511(c), which imposes gift tax on transfers to certain trusts that previously wouldn’t have been taxable.

Until recently, Sec. 2511(c) received little attention. After all, few thought it would ever see the light of day. Once it was clear that the estate tax repeal would become a reality, estate planning advisors began to take a closer look and, to many, the provision’s ambiguous language suggested tax consequences that Congress arguably didn’t intend. On February 16, 2010, the IRS published Notice 2010-19 to clear up the confusion. Unfortunately, the Notice itself highlights another unintended consequence of the law.

Where Things Stand Now

During the last nine years, EGTRRA gradually reduced the federal gift, estate and generation skipping transfer (GST) tax rates and increased the amounts of wealth that were exempt from tax. In 2009, the top transfer tax rates stood at 45%, the estate and GST tax exemptions at $3.5 million and the lifetime gift tax exemption at $1 million.

This year, the estate and GST taxes have disappeared, the gift tax rate has dropped to 35% and the gift tax exemption remains at $1 million. Next year, the tax rates and exemption amounts revert to the levels prescribed by pre-EGTRRA law. That means that in 2011, absent new legislation, all three transfer taxes will apply at a top rate of 55%, with an exemption amount of $1 million (though the GST exemption will be indexed for inflation).

Going hand-in-hand with the 2010 repeal is a significant change related to income tax on inherited assets. Until 2009, inherited property generally received a “stepped-up” income tax basis equal to its fair market value on the date of death. This allowed recipients to sell the property immediately without triggering capital gains taxes.

Under EGTRRA, in 2010 only, the automatic step-up in basis is eliminated. Instead, estates are permitted to allocate up to $1.3 million to step up the basis of certain assets plus an additional $3 million for assets left to a spouse.

What does this mean? In some cases, the families of people who die in 2010 with substantial amounts of appreciated assets will, from a financial perspective, potentially be worse off than they would have been in 2009, because their capital gains tax liability could exceed any estate tax liability that would have applied had their loved ones died in 2009.

Transfers in Trust

So how does Sec. 2511(c) fit in? Congress added it to discourage affluent taxpayers from using irrevocable nongrantor trusts to shift income to family members in lower tax brackets.

Before 2010, taxpayers could use these trusts, for instance, to shift income to the trust or its beneficiaries while avoiding gift tax by retaining certain powers, such as the right to change beneficiaries. By structuring the trust in this way, the transfer wasn’t considered a “completed gift,” so gift tax didn’t apply. Because the gift was incomplete, however, the trust assets remained in the taxpayer’s estate and were eventually subject to estate tax and qualified for the step-up in basis.

Congress was concerned that repeal of the estate tax would allow taxpayers to use these trusts for income shifting while circumventing both gift and estate taxes. To avoid this result, Sec. 2511(c) provides that — in 2010 only — transfers in trust are considered completed gifts for tax purposes unless the trust is treated as wholly owned by the donor or the donor’s spouse under the grantor trust rules. A grantor trust is treated as the donor’s property for income tax purposes, so income shifting isn’t a concern.

Widespread Confusion

Despite Congress’s seemingly straight-forward intentions, Sec. 2511(c) has created widespread confusion. The section clearly provides that transfers to nongrantor trusts are completed gifts for gift tax purposes, but some have interpreted it to mean that the converse is also true — that transfers to grantor trusts in 2010 are not completed gifts.

This interpretation is problematic for a couple of reasons. First, assuming that Congress doesn’t restore the estate tax retroactively, it suggests that taxpayers can transfer enormous amounts of wealth free of both gift and estate taxes simply by placing assets in a grantor trust this year.

Second, it calls into question the continued efficacy of popular estate planning strategies, such as grantor retained annuity trusts (GRATs). GRATs are typically structured as grantor trusts for income tax reasons, but their ability to reduce transfer taxes depends on contributions being treated as completed gifts.

Clarification Leads to CRT Questions

Notice 2010-19 clarifies that Sec. 2511(c) isn’t intended to exclude from gift tax any transfers to grantor trusts that would otherwise have been taxable under previous law. The Section simply “broadens the types of transfers subject to [gift tax] to include certain transfers to trusts that, before 2010, would have been considered incomplete and, thus, not subject to the gift tax. Accordingly, each transfer made in 2010 to a trust that isn’t [a grantor trust] is considered to be a transfer by gift of the entire interest in the property under Sec. 2511(c).”

Unfortunately, while the notice clarifies the ambiguities described earlier, the last sentence quoted above raises serious concerns about transfers to qualified charitable remainder trusts (CRTs). CRTs are nongrantor trusts, but they don’t involve the income-shifting Congress was trying to prevent.

Nevertheless, a literal reading of Sec. 2511(c) suggests that the entire amount transferred to a CRT is a taxable gift, which would be partially offset by the gift tax charitable deduction. Previously, contributions to qualified CRTs weren’t subject to gift tax. It seems clear that Congress didn’t intend this result, and it’s hoped that the IRS will issue guidance stating that Sec. 2511(c) doesn’t apply to CRTs.

An Uncertain Future

An effective estate plan depends on predictable estate and income tax rules. It’s difficult to plan for the transfer of wealth in the most tax-efficient manner if those rules change dramatically from year to year.

As things stand now, strategies that worked in 2009 may be ineffective — or even counterproductive — in 2010. For example, wills and trusts that use formulas tied to the applicable exemption amount may produce unexpected (and unwelcome) results in 2010. And strategies that make sense in 2010 may be inappropriate in 2011.

Making matters worse, Congress is likely to change the rules again, but we don’t know how or when that will happen. For example, Congress might:

  • Do nothing, allowing the one-year repeal to stand and the pre-EGTRRA tax regime to return in 2011,
  • Reinstate the 2009 tax regime (with or without modifications) retroactively to January 1, 2010, or
  • Reinstate the 2009 tax regime (with or without modifications) prospectively.

Retroactive reinstatement likely would result in litigation over its constitutionality, which could lead to years of uncertainty about the tax treatment of 2010 transfers made before such legislation is signed into law.

Be Prepared Given the uncertainty over the future of the estate tax, review your plan with your advisors to determine the impact of the repeal. You should also discuss strategies that can help you adapt your plan to the changes that are sure to come.

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